Should you use your borrowing rate as the cost of debt?

Should you use your borrowing rate as the cost of debt?

Farmantra

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The company ABC borrowed 50 M USD at 2% interest rate 3 years ago. What should be the cost of debt in calculating the cost of capital of the company? Should you use 2% as the cost of debt as that’s the interest expense you are supposed to pay? In order to understand this, let us understand the fundamentals of cost of debt.

What is actually the cost of debt? It’s the cost of borrowing long term today.

Why long term?

The company can argue that by using short-term debt, it would lower its effective cost of debt. This is true as the short term rates tend to be lower than that of long-term rates in most of the developed markets. However, that does not explain the definition of hurdle rate as the hurdle rate for an investor is the return he needs to make in the long term to break-even his investment on the stock. In any case, a firm that funds long term projects with short-term debts will have to come back to the market to roll over the debt.

Why today?

The company ABC has 50 M USD debt on its books and the interest expense is 10 M USD. Let’s assume that the risk free rate today is 7%. If you use the book interest rate of 2% in the cost of capital calculations, you are expecting the projects funded with that capital to earn more than 2% to be considered a good investment. If that is the case, you would better invest that money in treasury bonds and earn 7% without any risk.

This explains that you should never use your borrowing rate as the cost of debt in your hurdle rate calculations.